Uncle Sam and Congress have long distinguished between income paid due to a person’s individual effort, such as wages or self-employment earnings, and income received from the profitable sale of assets knows as capital. Wages and salaries are classified as ordinary income. Gain from the sale of a capital asset is termed a capital gain. Gains from the sale of capital assets that meet certain requirements are generally accorded more favorable tax treatment than ordinary income.
- Capital assets: The law defines the term capital asset in a negative sense by first declaring that all types of property are capital assets, and then listing certain exceptions, see IRC Sec. 1221. Assets such as stocks, bonds and other securities held by individuals are capital assets. In general terms, assets that are held for investment purposes are capital assets. Some assets are not capital assets by definition, but may be treated as such if used in a trade or business and sold or exchanged at a gain.
- Holding period: This is the length of time an asset is owned, beginning on the day after it is acquired and ending on the day it is disposed of. The amount of time an asset has been held impacts the tax treatment of any gain or loss when the asset is sold. The law currently provides for two holding periods: short-term and long-term. Short-term assets are those held exactly 12 months or less. Long-term assets are those held more than 12 months.
At the end of a tax year, a taxpayer’s capital gains and losses are totaled and compared. If losses exceed gains, a taxpayer may use up to $3,000 of losses to offset other ordinary income – $1,500 if married filing separately. Losses that exceed the $3,000 limit may be carried to future tax years until used up. If a taxpayer dies, any un-used capital loss is gone forever; it may not be carried over to future tax years.
Ordinary income such as wages and salaries can be taxed at marginal federal income tax rates as high as 39.6%. Short-term capital gains are treated as ordinary income, taxable at the taxpayer’s highest rate. Long-term capital gains are taxed at rates which are capped and which may be less than a taxpayer’s regular rate.
Capital Gains Tax Rates
The past few years have seen many changes in the federal income tax treatment of capital gains. The American Taxpayer Relief Act of 2012 (ATRA 2012), generally effective January 2, 2013, made permanent many of the tax code provisions in effect for 2012.
Special Rules for Personal Residence
Under current law, a taxpayer may exclude from income up to $250,000 of gain from the sale of a principal residence if the taxpayer has owned and used the property as his or her principal residence for at least two years of the five-year period ending on the date of the sale or exchange. Only one such exclusion is permitted every two years.
If married filing a joint return, the maximum exclusion amount is increased to $500,000 if (a) either spouse meets the ownership requirement; (b) both spouses meet the use requirements and (c) neither spouse is ineligible because of the one sale every two years rule. If a married couple does not meet the requirements the amount of gain eligible for exclusion is the sum of the amounts to which each spouse would be entitled if they had not been married.
The law also provides for a reduced maximum exclusion for taxpayers who do not meet the requirements to qualify for the full $250,000 ($500,000 if married) exclusion and who sell or exchange a principal residence because of changes in place of employment, health or unforeseen circumstances.
A member of the U.S. Armed Forces, U.S. Foreign Service, Peace Corps volunteers or specified members of the intelligence community serving on qualified extended duty may choose to suspend the five year priors of use and ownership for to ten years.
Timing of Capital Gains Transactions
Note that a taxpayer generally controls when a capital asset will be sold and can, therefore, choose the year in which a gain or loss is to be included in their taxable income.
Seek Professional Guidance
The income tax treatment of capital gains and losses is complex and often confusing. Individuals facing decisions concerning the tax implications of the sale or exchange of a capital asset are strongly advised to first consult with a CPA, IRS enrolled agent or your financial advisor.
This information is for educational purposes and should not be considered specific financial, tax or legal advice. Always consult with a qualified advisor regarding your individual circumstances. Investment Advisory Services offered through Global Financial Private Capital, LLC, an SEC Registered Investment Adviser.
Brad Zucker, RFC® is the president of Safe Money Advisors, Inc., a Las Vegas-based independent financial advisory firm. He blogs on personal finance every Monday for the RJ. For more information visit www.SafeMoneyAdvisorsNV.com or connect with him viaFacebookandLinkedIn.